Inherited Annuity Rules: Taxes, Payout Options and Beneficiaries

Can You Inherit an Annuity?

Yes, when an annuity owner dies, the named beneficiary receives the remaining contract value directly from the insurance company, bypassing probate in most cases.

That said, not every annuity has an inheritable balance. A life-only annuity pays solely during the annuitant’s lifetime and leaves nothing behind. Most deferred annuities and any contract in the payout phase with a period-certain or joint-life structure, do carry a death benefit that can be transferred to a beneficiary.

What happens after that depends on two things: whether the annuity is qualified or non-qualified, and whether the beneficiary is a spouse or a non-spouse.

How Does Inheriting an Annuity Work?

Inheriting an annuity is a claim process: the beneficiary contacts the insurance company, submits a certified death certificate and proof of identity, and then elects a distribution method, typically within 60 days to one year of the owner's death.

Two factors shape what options are available:

• Whether the annuity was in the accumulation phase (still growing) or already paying out income at the time of death.
• Whether the beneficiary is a surviving spouse or a non-spouse.

For deferred annuities that haven’t yet started paying out, the full account value, including all accumulated gains, is available to the beneficiary. Some products may also include enhanced death benefits that exceed the account value. This is where distribution rules and tax planning matter most.

Inherited Annuity Rules: What Beneficiaries Need to Know

The IRS⁵ divides beneficiaries into two categories, surviving spouses and non-spouses, and each group faces different distribution deadlines, tax rules, and payout options.

Spouse Beneficiary Rules

A surviving spouse has the most flexibility of any beneficiary. The primary option is spousal continuation, where the spouse assumes full ownership of the contract and treats it as their own.

This means:

• Taxes on accumulated gains are deferred until distributions begin.
• Required Minimum Distributions (RMDs) are not required until age 73.¹
• All original contract benefits and riders remain intact.

Spouses may also choose to annuitize the contract, take a lump-sum payment, or roll qualified proceeds into an inherited IRA.

Non-Spouse Beneficiary Rules

Non-spouse beneficiaries cannot assume ownership or defer distributions indefinitely. They must begin taking money out within a set timeframe:

• Non-qualified annuities: The five-year rule applies. The full balance must be distributed within five years of the owner’s death.
• Qualified annuities (post-SECURE Act): Most non-spouse beneficiaries must empty the account within 10 years. If the original owner had already begun Required Minimum Distributions, annual RMDs are also required during that 10-year window, per IRS final regulations issued July 19, 2024 and effective for distribution years beginning in 2025.³
• Stretch option: Some contracts allow distributions spread over the beneficiary’s life expectancy, but this must be elected within the contract’s specified window, sometimes as short as 60 days.

Qualified vs. Non-Qualified Inherited Annuity

The single most important factor in your tax liability as a beneficiary is whether the annuity was qualified (funded with pre-tax dollars, fully taxable) or non-qualified (funded with after-tax dollars, only earnings taxable).

• Qualified annuities are funded with pre-tax dollars inside a retirement account such as an IRA or 401(k). Every dollar distributed is fully taxable as ordinary income.
• Non-qualified annuities are purchased with after-tax money outside of retirement accounts. Only the earnings above the original contributions are taxable. The principal comes back tax-free.

Read more on Qualified vs Non-Qualified Annuity: Key Differences

Inherited Non-Qualified Annuity Distribution Rules

A surviving spouse has the unique option to continue the contract as their own. For all other beneficiaries, non-qualified inherited annuities have three primary distribution options. Before reviewing them, one rule applies across most partial withdrawals: the Last In, First Out (LIFO) rule. 

All withdrawals are treated as coming from taxable earnings first, with one exception: the stretch option, which instead follows the exclusion ratio described below. You will not begin recovering your tax-free cost basis until all accumulated gains have been distributed.

Option 1: The Five-Year Rule

The entire account balance must be fully distributed by December 31 of the fifth year following the owner’s death. There is no requirement to take money out each year, you could take it all in year one, spread it evenly across five years, or wait and take everything at the end.

The tradeoff is that because of LIFO, any early withdrawals you take are almost entirely taxable earnings. If you’re trying to manage your tax bracket, timing these withdrawals strategically matters.

Option 2: The Stretch Option (Life Expectancy Payouts)

Some contracts allow distributions to be spread over the beneficiary’s life expectancy, typically through annuitization, in which case the exclusion ratio would apply to determine the taxable portion of each payment. This is often the most tax-efficient path for large inherited annuities, smaller annual distributions mean a lower yearly tax bill, and the undistributed portion can continue growing tax-deferred.

The catch: this option must be elected within the contract’s specified window, typically 60 days to one year from the date the death benefit is claimed. It is not available to all beneficiaries, estates, most trusts, and charities generally cannot use it. And once elected, the payment schedule is largely locked in.

Option 3: Lump Sum Distribution

You receive the full account value in a single payment. Simple, fast, and clean, but almost always the most tax-costly option.

All accumulated earnings become taxable ordinary income in that one year. For example, if you inherit a non-qualified annuity with an $80,000 cost basis and a current value of $150,000, that $70,000 in gains gets added to your gross income for the year, potentially pushing you into a higher tax bracket.

Inheriting an Annuity From a Parent

When you inherit an annuity from a parent, spousal continuation is not available. You are a non-spouse beneficiary and are subject to standard distribution rules. The tax implications can be significant, especially if the annuity has grown substantially over many years.

Inherited annuities do not receive a step-up in cost basis. Every dollar of gain your parent accumulated is taxable to you as income in respect of a decedent.

Steps to take after inheriting a parent's annuity:

1. Contact the insurance company promptly: Request claim forms and the original contract. You will need a certified death certificate and your own identification.
2. Confirm whether the annuity is qualified or non-qualified: This determines which distribution rules and tax obligations apply.
3. Calculate the accumulated gain: Subtract the original cost basis from the current account value to understand your full tax exposure.
4. Note the election deadline: The window to choose your distribution method may be as short as 60 days from the date the death benefit is claimed.
5. Consult a CPA or tax advisor before making any elections: Distribution decisions are largely irreversible and carry long-term tax consequences.
6. If available, request the stretch option from the insurer to spread distributions and reduce your annual tax burden.
7. Consider your income for each year going forward: Taking distributions in lower-income years can reduce your effective tax rate.

Tax Implications of an Inherited Annuity

Inherited annuity distributions are taxed as ordinary income, not at the lower capital gains rate, and no step-up in cost basis applies, meaning all gains accumulated during the original owner's lifetime are fully taxable to you.

No Step-Up in Cost Basis

Under Internal Revenue Code Section 1014, inherited assets like stocks and real estate generally receive a step-up in basis to fair market value at the date of death. Annuities are explicitly excluded.⁴ Every dollar of gain accumulated during the original owner’s lifetime is fully taxable to the beneficiary.

Ordinary Income, Not Capital Gains

This matters more than most people expect. Long-term capital gains are taxed at 0%, 15%, or 20% depending on your income. Ordinary income is taxed at rates up to 37%. When you inherit a large annuity with significant gains and take distributions, those distributions are taxed at your marginal rate, not the preferential capital gains rate.⁵

State Taxes

Federal taxes aren’t the only concern. Many states also tax annuity distributions, some at full income rates. A few offer partial exclusions. The combined federal and state tax burden on a large lump-sum can be substantial. Consulting a tax professional who understands your state’s rules is strongly advisable before making any distribution election.

Read: Period Certain Annuity: Guaranteed Payments Explained

How to File Taxes on an Inherited Annuity

You report inherited annuity distributions using Form 1099-R, which the insurance company issues each year you receive a payment; the taxable portion is entered on Line 5b of Form 1040 and is never subject to the 10% early withdrawal penalty, regardless of your age.⁶

Key details to know:

• Distribution Code 4 on the 1099-R indicates a death benefit payment: This means the 10% early withdrawal penalty does not apply, regardless of the beneficiary's age.
• Report the total distribution on Line 5a of Form 1040 and the taxable portion on Line 5b.
• For qualified annuities, Lines 5a and 5b will match, since the full amount is taxable.
• For non-qualified annuities on a stretch payout, an exclusion ratio determines the tax-free and taxable portions of each payment.

How the exclusion ratio works:

Divide the original cost basis by the total expected payments over the distribution period. That percentage of each payment is tax-free; the remainder is taxable ordinary income.

Example: Cost basis of $100,000 divided by expected total payments of $300,000 equals a 33.3% exclusion ratio. One-third of each payment is tax-free; two-thirds is taxable. Once the full $100,000 basis is recovered, every subsequent payment is fully taxable.

The insurance company can typically confirm the cost basis and help calculate the exclusion ratio. A CPA should review the calculation before you file.